Author: Scott Boothby, Managing Director, Head of High Yield Capital Markets, Corporate Finance, Commerzbank Corporates & Markets
High yield bonds were once widely viewed as a financing tool for weaker companies. However, this perception has evolved. Today high yield is seen as a competitive alternative to loan financing in Europe, providing companies with sufficient capital to meet their strategic growth needs, supported by a well functioning capital market and increasingly issuer-friendly terms.
Defining high yield
High yield refers to bonds issued with a sub-investment grade rating (i.e. lower than Baa3/BBB-). Companies rated in the double-B space are sometimes ex-investment grade companies called ‘fallen angels’ and typically achieve less restrictive terms than pure high yield companies. Issuers who are the subject of a highly leveraged buy-out, or smaller, more cyclical corporates, are typically rated in the single-B space and often come with a full set of high yield covenants.
The high yield ethos
Companies who issue high yield will typically have bank and/or institutional loans and revolving credit facilities that will be complemented by high yield. Whereas bank lending is primarily used for day-to-day and operational needs, high yield allows companies to get substantial long term capital on to their balance sheet to allow them to grow — be that through M&A, major capital expenditure or fundamental refinancing.
High yield debt is typically long term bullet tranches (standard maturities of seven years or more, although we have seen five/six years) and large scale to ensure sufficient liquidity for investors. Typically, the minimum acceptable issue size is €200m-€250m and/or a company with EBITDA of €50m plus.
As high yield bonds have increased in popularity in Europe, so a diverse investor base has also developed, with a high concentration of activity in London supplemented by local hubs in Frankfurt, Paris and Amsterdam. Demand is coming from traditional institutional investors such as pension funds, insurers and asset managers in a bid to meet their yield needs but also from credit and hedge funds and, to some extent, the resurgent collateralised loan/debt obligation (CLO/CDO) market who have some capacity to buy high yield.
Getting the right structure
One of the key benefits of high yield debt versus traditional bank facilities is the operational flexibility it offers. Transactions are underpinned by incurrence covenants rather than the more onerous maintenance covenants demanded by senior bank debt notwithstanding the relatively new covenant-lite trend for institutional loans. High yield covenants may require a limitation on the incurrence of additional debt, on asset sales or mergers and use of cash but these conditions tend to evolve during the high yield marketing process in line with investor feedback and will still tend to be more flexible than the terms on traditional loans.
To give investors assurance that their investment won’t be refinanced suddenly, high yield bonds incorporate a non-call feature that usually lasts half the life of the bond (so a bond may be for seven years and non call for three) and makes early redemption expensive for the issuer. Conversely, to give issuers some leeway, bonds can incorporate certain redemption flexibility features, but again these are subject to negotiation with investors so as to limit the potential impact on their future returns.
Typically, bonds carry a fixed rate coupon. However, we have seen instances of floating rate notes (FRNs) which pay a rate that is periodically reset, reducing their sensitivity to the interest rate environment. FRNs tend to have a similar tenor as fixed rate notes but usually carry a one year non-call period, priced at 101% of par. Having said this, FRNs have been less prevalent in 2015, however.
Probably the most unfamiliar aspect of high yield issuance for debut issuers is the level of investor education required for what is a publicly traded instrument, both ahead of the issue and then as an ongoing after-market requirement.
Rather than just negotiating with a handful of relationship banks, a high yield transaction requires an intensive marketing process (pre-marketing, sounding out investors and roadshows) and then regular contact and reporting to a wide range of investors. This can seem cumbersome, particularly to debut issuers. But provided a company has strong governance and is well supported by its core banks, this should be viewed as an opportunity to widen and diversify the investor base, increase market awareness and provide greater funding flexibility. Furthermore, it serves as a valuable precursor to approaching equity capital markets in the future.
The other aspect that often concerns issuers (typically debut ones) is the credit rating process. To assist the issuer through the rating process, arranging banks will usually have a rating advisory capability, whereby expertise around the different methodologies used by S&P, Moody’s and Fitch for various industry sectors is provided. At Commerzbank, we have dedicated M&A bankers and rating experts to advise issuers on the key points to bring out when talking to the rating agencies. Agencies have their own particular requirements and it’s important to use that in any dialogue with them.
Choosing your lead bank
Issuing a high yield bond is an intensive process, typically taking seven to nine weeks from start to finish, and requires an experienced partner to ensure a successful transaction.
To date, the major investment banks have controlled the vast majority of transactions in Europe. But I would argue that Europe’s large commercial, or relationship, banks are becoming a more significant presence in the market.
To be competitive in the high yield market, a bank first requires a comprehensive high yield platform — including capital markets, credit syndicate, credit research and sales and trading expertise — plus a network of investor relationships to market an issue effectively. Furthermore, an issuer’s relationship bank also has the added advantage of having built up knowledge of the company over many years. For a debut issuer, this in-depth knowledge can distinguish a relationship bank from its competition.
In addition, the relationship bank will have the best insight into the issuer’s existing financing, ensuring it can recommend the most suitable high yield financing option.
A benign environment
The likely extension of quantitative easing in the Eurozone, low default rate, combined with high levels of liquidity and growing competition to invest from the CLO market all mean that the next 12 months should continue to see a very benign environment for high yield issuers in Europe. This, in turn, is allowing companies to lock into long term financing at what are broadly the most attractive rates to date in the European high yield market (subject to fluctuating market conditions).
Europe’s high yield market is still a fraction of the size of the US’s (2014 saw circa €72bn of issuance in Europe versus circa €237bn in the US, according to S&P). But with a more diverse issuer and investor base, the market has increased in maturity. Today, European corporates across almost every sector are benefiting from high yield as a financing tool and a means to diversify their sources of funding.
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